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Fonterra poised for growth in China, despite big regulatory change

Fonterra Cooperative Group chief executive Theo Spierings says there will be drastic changes in the Chinese infant formula market, with the removal of between 1800 and 2000 brands in the next 15 to 18 months.

Regulatory changes require each entity to have only three brands and three different recipes of infant formula in a bid to crack down on the grey market and allay consumers' food safety concerns by reducing fake formula.

Mr Spierings said Fonterra was well-positioned in every segment in China where it is already the global market leader for ingredients such as whole milk powder but a lot of things have changed in the past few years including a shift to sales from mother and baby shops to e-commerce.

The dairy cooperative, which has raised its forecast milk payout twice in as many months, posted a 65% gain in full-year profit as cost-cutting and cheaper milk made up for a revenue decline.

Profit rose to $834 million in the 12 months ended July 31, from $506 million a year earlier while revenue fell 9% to $17.9 billion. The overall result shows a big swing toward more value-add, which saw its return on capital rise to 12.4 percent from 8.9 percent the previous year.

"Our strategy is about ensuring we do everything we can to minimise the volatility in earnings but it's not going to go away," chairman John Wilson said. "There is no doubt to some extent profitability is positive because dairy prices are lower but you've seen us announce for next year a lift in our earnings forecast as milk prices are coming up."

This week Fonterra raised its forecast payout for the current season by 50c/kgMS to $5.25/kgMS, for a total payout of $5.75-5.85 including forecast earnings of 50-60c available for distribution.

Recovery in China demand

Greater China, Fonterra's key market, produced earnings before net finance costs and tax of $64 million through its China farm division, which includes two farming hubs, increased annual losses to $59 million, up from $44 million, due to weak global milk prices during the year.

There was a recovery in Chinese demand, with dairy imports up 27% this year and Fonterra had 48% volume growth to one billion litres in its consumer and food service business there, which is continuing to expand in mainland China, Hong Kong and Taiwan.

Milk production from its 10 China farms hit 230 million litres and a third farming hub is now being developed under a joint venture with Abbott Laboratories, which will use some of the milk produced.

Mr Wilson said the cooperative was satisfied with that level of farm development at this stage, having revised its original intention to produce one billion litres of milk out of China.

"With these two hubs we will be producing between 300 and 400 million litres and we're very comfortable with that which is at a critical mass that we can now make the right decision on what do with that fresh milk into our consumer and food service brands and products and key Chinese customers' local businesses," Wilson said. "We will make those decisions in coming months, rather than years, on what do with that."

Integrating the Chinese fresh milk, currently sold on the spot market, into its other operations in China won't necessarily mean Fonterra building a processing factory in that country as Mr Wilson said it could be done by third-party manufacturers instead.

"The Chinese market is evolving so rapidly. That's why ingredients out of New Zealand are so important and any manufacturing in China will be supplementing ingredients from New Zealand with a fresh dairy offering from China and we need both as that market evolves, particularly down the east coast of China," he said.

Mr Spierings said 100% of the milk used for its products in China is produced from New Zealand but over time he could see that shifting to 80% from New Zealand and 20% from its Chinese farms.

There were plenty of questions at today's results briefing on Fonterra's $747 million investment last year in Chinese infant formula maker Beingmate which warned investors it was anticipating a first-half loss of up to 230 million yuan. Its share price has dropped from the 18 yuan a share that Fonterra paid for its 18.8% stake to 11.67 yuan. The tie-up includes a distribution deal for Fonterra's Anmum infant formula brand.

This week Fonterra also got Australian and Chinese government approval for its joint venture with Beingmate to buy Fonterra's infant formula plant at Darnum in Australia, which Mr Wilson said will mean product destined for Beingmate's Chinese customer will now start rolling off the production line.

The Darnum joint venture is a key component of Fonterra's partnership with Beingmate to create a fully integrated global supply chain from the farmgate direct to Chinese consumers using Fonterra's milk pools and manufacturing sites.

Mr Wilson said the Beingmate investment was part of a wider strategy in China that was now starting to come together.

"We'd like to see the Chinese infant formula business be far more in balance and we anticipate that happening in the next 12 months," he said.

For the overall business, around 4000 "transformation" initiatives delivered $2.2 billion in free cashflow, of which $1.6 billion was used to reduce its debt to $5.5 billion, lowering its debt gearing ratio to 44.3% from a record high 49% the previous year.

Mr Wilson said the debt gearing would have fallen to 42% if it hadn't used the strength of its balance sheet to support its farmer shareholders through tough times after two years of low payouts, by advancing payments and a support loan.

"We have used the strength of the co-op paying down that debt to get cashflow flowing through to our farmers and still delivered a strong balance sheet for the co-op," he said. "That's the important thing, getting the balance right."

Fonterra also turned around its loss-making Australian operations, delivering a $63 million earnings before interest and taxation compared to a $92 million loss last year after what Mr Spierings said was "big changes in milk prices that were not connected to what was being earned in the market."